Applying The New SEC Staff Guidance On Non-GAAP Measures To Your Next Earnings Announcement - Corporate and Company Law

On May 17, 2016, the SEC's Division of Corporation Finance escalated the SEC's efforts to curb perceived misuse of non-GAAP financial measures with the issuance of a revised set of Compliance and Disclosure Interpretations (CDIs). This action follows a series of speeches by SEC Chair Mary Jo White and SEC senior staff members, and an uptick in comment letter activity, all focused on what a member of the SEC staff described in one speech as a "troubling increase over the past few years in the use of, and nature of adjustments within, non-GAAP measures by companies."

All public companies should consider and address the SEC staff's new guidance, as well as other recent developments regarding the use of non-GAAP measures, as they prepare for their next earnings announcement. To help you work through the implications of the new guidance, we discuss below the new and revised CDIs, and offer our analysis of key takeaways and action items.

Equal or Greater Prominence

For many companies, the most significant changes will result from the more prescriptive approach the staff has taken to the "equal or greater prominence" requirement. As explained below, the guidance unambiguously sets forth the staff's view that GAAP measures must be presented first, and must also be discussed and analyzed narratively. While companies may be unhappy about this new rigid approach, implementation of new CDI 102.10 should ultimately be more straightforward than the application of some of the other changes discussed below.

Question 102.10

Question: Item 10(e)(1)(i)(A) of Regulation S-K requires that when a registrant presents a non-GAAP measure it must present the most directly comparable GAAP measure with equal or greater prominence. This requirement applies to non-GAAP measures presented in documents filed with the Commission and also earnings releases furnished under Item 2.02 of Form 8-K. Are there examples of disclosures that would cause a non-GAAP measure to be more prominent?

Answer: Yes. Although whether a non-GAAP measure is more prominent than the comparable GAAP measure generally depends on the facts and circumstances in which the disclosure is made, the staff would consider the following examples of disclosure of non-GAAP measures as more prominent:

Presenting a full income statement of non-GAAP measures or presenting a full non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures;
Omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures;
Presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font) that emphasizes the non-GAAP measure over the comparable GAAP measure;
A non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption);
Describing a non-GAAP measure as, for example, "record performance" or "exceptional" without at least an equally prominent descriptive characterization of the comparable GAAP measure;
Providing tabular disclosure of non-GAAP financial measures without preceding it with an equally prominent tabular disclosure of the comparable GAAP measures or including the comparable GAAP measures in the same table;
Excluding a quantitative reconciliation with respect to a forward-looking non-GAAP measure in reliance on the "unreasonable efforts" exception in Item 10(e)(1)(i)(B) without disclosing that fact and identifying the information that is unavailable and its probable significance in a location of equal or greater prominence; and
Providing discussion and analysis of a non-GAAP measure without a similar discussion and analysis of the comparable GAAP measure in a location with equal or greater prominence. [May 17, 2016]

Key Takeaways and Action Items

The equal or greater prominence rule applies to SEC filings and to communications, such as the earnings release, that are furnished to the SEC under Item 2.02 of Form 8-K. It does not apply to communications that are not filed or furnished at all or that are furnished under Item 7.01 of Form 8-K. When drafting earnings-related communications, it is important to know whether and how the communication will be filed or furnished, and extra care must be taken in the event of any last-minute changes to the company's communications plan.
While the equal or greater prominence rule does not apply to the typical earnings conference call or supplemental materials a company may make available in connection with its earnings announcement (unless those items are furnished under Item 2.02 of Form 8-K or filed), you should nevertheless ensure that such communications are not misleading. As discussed below, the staff is now reading the "not misleading" prohibition in Regulation G more broadly than in the recent past.
For communications that are subject to the equal or greater prominence rule, present the GAAP measure before the related non-GAAP measure. The current practice of having subheadings that lead off with a non-GAAP measure and end with the related GAAP measure is simply no longer permissible under the staff's new guidance.
Beyond always presenting the GAAP measure first, companies that currently limit their discussion and analysis of results to non-GAAP measures will now need to add a more prominent discussion and analysis of their GAAP measures. Merely presenting the GAAP number once (notwithstanding that it comes first), followed by pages of only non-GAAP numbers, discussion and analysis, is not consistent with the staff's new guidance and will invite staff comment.
The prominence requirement affects management quotes just as it affects other parts of the earnings release, so care will need to be taken to draft those quotes in a way that does not give greater prominence to non-GAAP measures (for example, by only talking about "record performance" in the context of the company's non-GAAP measures without also talking about the GAAP results—as specifically noted in the new interpretations).
Companies that provide guidance on only a non-GAAP basis will need to make more prominent and fulsome their explanations of why it would be unreasonably burdensome to provide guidance on a GAAP basis, known adjustment items and the significance of unknown adjustment items.

Practices That May Be Considered Misleading

The most challenging new CDIs to apply are likely to be the four new ones that highlight practices that the SEC staff has indicated it believes may be misleading, and therefore prohibited under Regulation G from any public disclosure.

Question 100.01

Question: Can certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading?

Answer: Yes. Certain adjustments may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading. For example, presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant's business could be misleading. [May 17, 2016]

Question 100.02

Question: Can a non-GAAP measure be misleading if it is presented inconsistently between periods?

Answer: Yes. For example, a non-GAAP measure that adjusts a particular charge or gain in the current period and for which other, similar charges or gains were not also adjusted in prior periods could violate Rule 100(b) of Regulation G unless the change between periods is disclosed and the reasons for it explained. In addition, depending on the significance of the change, it may be necessary to recast prior measures to conform to the current presentation and place the disclosure in the appropriate context. [May 17, 2016]

Question 100.03

Question: Can a non-GAAP measure be misleading if the measure excludes charges, but does not exclude any gains?

Answer: Yes. For example, a non-GAAP measure that is adjusted only for non-recurring charges when there were non-recurring gains that occurred during the same period could violate Rule 100(b) of Regulation G. [May 17, 2016]

Question 100.04

Question: A registrant presents a non-GAAP performance measure that is adjusted to accelerate revenue recognized ratably over time in accordance with GAAP as though it earned revenue when customers are billed. Can this measure be presented in documents filed or furnished with the Commission or provided elsewhere, such as on company websites?

Answer: No. Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Rule 100(b) of Regulation G. Other measures that use individually tailored recognition and measurement methods for financial statement line items other than revenue may also violate Rule 100(b) of Regulation G. [May 17, 2016]

Key Takeaways and Action Items

This series of CDIs generally refers to items that "can," "could" or "may" be misleading. While this leaves some discretion to companies to address potential concerns via fulsome disclosure, it also preserves an opportunity for the SEC staff to second-guess the company.
Be transparent about any changes made to how you define your non-GAAP measures, or any changes to the methodology used to calculate them. Particular care should be taken with respect to changes that arise in the context of integrating recently acquired companies.
The reference in CDI 100.01 to "normal, recurring, cash operating expenses" does not affect the common practice of companies excluding stock compensation expense, since that is a non-cash item.
Carefully evaluate whether there are positive items (like litigation victories, disposition gains, or other non-recurring or unusual gains) comparable in character, significance or magnitude to items that the company adjusts out of its non-GAAP measures and that should likewise be adjusted for. A longtime criticism of non-GAAP measures has been that they are used to highlight "everything but the bad stuff." When used properly, non-GAAP measures should adjust for items that affect period-to-period comparability, whether favorably or unfavorably.
CDI 100.04, relating to adjustments to revenue measures, is likely to be the most difficult of all the new CDIs for companies that currently present such adjustments. Companies that provide operational metrics regarding bookings or billings will also want to be careful to avoid any suggestion that these operational metrics are being presented as an alternative measure of revenue.
Among other things, avoiding being misleading means being very clear about whether numbers discussed are on a GAAP or non-GAAP basis and avoiding ambiguous titles for non-GAAP measures. In the current environment, it may also be prudent to include and discuss GAAP measures in communications that are not subject to the equal or greater prominence requirement to a greater extent than in the past or than is technically required by the rules. In any event, as required by current rules, any public communication containing non-GAAP measures must include the most directly comparable GAAP measures and a reconciliation.

Presenting Liquidity Measures on a Per Share Basis

Three CDIs were revised (as shown below in the redline comparison to the prior versions of these CDIs) to emphasize the staff's longstanding position that liquidity measures, such as free cash flow, may not be presented on a per share basis.

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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.